Recent Delaware Case Highlights Common Pitfalls to Avoid With Earn-Out Provisions

Most people in the M&A business have encountered earn-outs in one form or another in attempting to structure transactions to close pricing gaps between buyers and sellers.  Most also know that earn-out provisions often involve contentious negotiation and, frequently, disputes, sometimes leading to litigation.  A recent case in the Delaware Court of Chancery, Airborne Health, Inc. and Weil, Gotshal & Manges LLP v. Squid Soap, LP (November 23, 2009), is yet another example of the propensity of earn-outs to go bad and provides reminders of common pitfalls parties should attempt to avoid when drafting these provisions.

Squid Soap had developed a germ-prevention product for children designed to increase the amount of time they spend washing their hands.  Airborne Health, a maker of dietary supplements to support the immune system, acquired Squid Soap’s assets under an agreement that paid Squid Soap $1 million at closing, with an earn-out of up to an additional $26.5 million if certain targets were achieved.  Because Squid Soap was very bullish on its product and apparently was unsure whether Airborne Health would successfully market it, the agreement also provided that Airborne had to return the assets to Squid Soap if Airborne had not spent $1 million on marketing the product and achieved $5 million in net sales in the first 12 months following the closing.

Airborne’s business ran into trouble shortly after acquiring Squid Soap’s assets (principally lawsuits and government investigations into the validity of Airborne’s marketing claims about its products) and it did not meet the earn-out financial requirements that would entitle it to keep the Squid Soap assets.  Nor, of course, were the earn-out thresholds met that would have entitled Squid Soap to additional payments.  While Airborne was willing to return the assets and attempted to do so on several occasions, Squid Soap, for its part, preferred to pursue litigation against Airborne.  Squid Soap’s principal claims were that Airborne had failed to disclose the litigation pending against it at the time of the transaction and misrepresented its marketing prowess in inducing Squid Soap to entrust sales of its products to Airborne.

Airborne and its counsel, Weil, Gotshal & Manges, LLP, succeeded in having the claims against them dismissed and having the court declare Airborne had not breached its agreement with Squid Soap.  Squid Soap lost its case principally because it had not negotiated either for representations from Airborne regarding the strength and quality of its marketing program (which Squid Soap claimed to have relied on) or for promises from Airborne regarding the effort and expense it would devote to the marketing effort.  The $1 million of marketing expense referred to in the agreement was merely a condition Airborne had to meet in order to keep the assets, not an affirmative obligation to actually spend the money.

Although prevailing in the litigation, Airborne was somewhat fortunate the court found Squid Soap had not made specific enough claims regarding the alleged misrepresentations about Airborne’s marketing ability.  Otherwise, the court would have allowed those claims to proceed because Airborne had not included in its agreement a specific non-reliance provision.  This case and prior Delaware decisions make clear that an agreement must have an express provision disclaiming reliance on statements outside of the agreement in order to thwart those claims.  (See Goodwin Procter’s prior Client Alert on this topic, “Ruling in ABRY Partners v. Providence Equity Case Has Lessons for Buyers and Sellers”).

The takeaways from the Squid Soap case are:

• Earn-outs are fraught with risk and parties that use them should understand the likelihood of post-closing disputes.
• Sellers who do not negotiate for detailed performance covenants from buyers relating to achievement of earn-outs will have very few legs to stand on in the event of a dispute.
• Clear non-reliance provisions should be included in virtually any commercial agreement containing representations and warranties to ensure the deal is completely embodied in the four corners of the agreement.  Buyers, in particular, will want such provisions in deals with earn-outs or other post-closing obligations.
• The Delaware courts are unlikely to come to the aid of a sophisticated party that could have negotiated for contractual protections, but failed to do so.